Passive Investors Unite: We Blind Mice

Throughout man's bloody history of conflict, time and again it is the hand defending the faith that lights a fuse. Is this because, by its very nature, faith is blind and can only promise abundant spiritual rewards for the here and now, while saving its true rewards to bestow in the afterlife? Does it take the strength of a warrior to defend and die for it? Name a faith and you are sure to encounter a struggle.

The Protestant Reformation certainly had its fair share of strife. In 1517, Martin Luther, angered by the selling of indulgences, pounded his 95 theses on a chapel door. Aided by the advent of the printing press, he began spreading the word and paving the path to Protestantism. He could never have guessed that less than a century later, the defense of his faith would spawn ghastly nursery rhymes that were anything but spiritual.

One of those rhymes is the well known, but perhaps not deeply pondered, Three Blind Mice of so many a nursery setting. Before Queen 'Bloody' Mary I inspired that spicy drink with a side of celery to be concocted in her gory memory, she stirred 17th century nannies to seemingly innocent singalongs. Written in 1609, the mice are said to represent three loyalist Protestant noblemen or bishops, depending on history's recollection, who dared to question the Papist queen's mental state and thus attempt her overthrow. The farmer's wife in the nursery rhyme was of course the queen, who with her husband, King Philip of Spain, owned many large arable estates. Being less than amused by the Protestant's fervor, the farmer's wife chose for their demise not a knife, but a burning stake. From whence, we must ask, does blindness enter the unseen picture? Historians suggest the author to have been a crypto-Catholic alluding to the inherent blindness of Protestantism's proselytes. Clever indeed.

Tomorrow's writers could be inspired to pen a similar tale of intellectual rebellion, albeit in reverse scale, as scores of original thinkers dwindle in number. The future rhyme could well be titled, The Last Stand of Active Investors. Few would question the fiery fate that's been met by increasing ranks of yesteryear's active managers. Do they not comprehend, the blindly accepting masses implore, the scholarly supremacy of index investing? Just recently, the godfather of passive investing, the Vanguard himself, John Bogle, predicted that it would only be a matter of years before Fidelity Investments departed this world. Free yourself now or dare to perish!

Ah, the joys of blaspheming the conventional wisdom.

Forward thinkers see what's to come and it's not for the faint of heart. In one word, this megatrend of the ages will end in tears, rivers of tears. The wider the flock netted, the deeper the pain that will follow.

But first, a huge caveat. This tale of what the future holds is in no way a defense of the many active managers who are stuck in what can only be described as a costly time warp, in utter denial that the rules of the game changed long ago, leaving them behind. Like it or not, the Federal Reserve matters more today than any bottoms-up analysis acumen. Did the shift occur overnight? Of course not.

In the years that followed the 1987 stock market crash, the Fed's mission creep started to chip away at pure price discovery. Loose monetary policy first flashed its ugly underbelly in the late 1990s when distinguishing between companies capable of turning a profit proved much less valuable than getting in on the next hot IPO. Until the music stopped.

Stock picking made a comeback, for a time. Soon enough, though, the mania resumed. The housing bubble fed a feverish corporate buyback cycle, once again mitigating the value-add of differentiation. It's worth noting that passive investing was nurtured in each of these eras. In the late 1990s, investors bought the 'Qs,' as in the exchange traded fund (ETF) that tracked the top 100 Nasdaq stocks. Spider investing was all the rage in the early 2000s, as in ticker symbol SPY, the ETF that tracked the broader Standard & Poor's 500 index.

One distinct attribute of these boom/bust slices of history is what households were worth on paper vis-à-vis their disposable income. To be precise, that ratio hit 6.5 times at both cycles' peaks, which so happens to be the level above which it's been for the past five years. Without a doubt, it's high tide. Over $35 trillion has been tacked on to American's collective net worth since stocks bottomed in March 2009.

An added bonus to this wealth build has been passive indexing itself. That gets us to the tricky position in which so many blind and blissful investors find themselves today.

A trip 40 years down memory lane helps set the stage. August 31, 1976 marked the momentous birth of Vanguard's flagship fund that tracks the S&P 500. By the time the fund turned 20, assets under management had grown to a respectable $3 billion. Since then though, its growth has been breathtaking. The world's largest mutual fund has more than $200 billion chocking its coffers. It's noteworthy that the firm that put indexing on the map also boasts the second and third largest funds gauged by assets under management, also flown under the Vanguard flag.

Stepping back to the biggest picture, since 2008, over $1 trillion has flooded into index funds in some form, helping passively managed stock funds and ETFs swell to comprise over 40 percent of the $8-plus trillion pie, double their share from a decade ago. On the losing end, over the past eight years, active stock managers have bled $600 billion and counting, and the trend is accelerating.

At the core of the exodus is the simple fact that nine out of ten active managers have underperformed their benchmark index over the past year, whether it be the S&P 500 or another bogey. It must be acknowledged that high and hidden fees have rightly earned investor ridicule over the years. That said, low fees are meaningless in the face of a full blown market rout.

The problem is these feeding frenzies morph into hunger strikes. In the case of index investing, returns beget performance chasing, a tendency that's as old as time. Because prices are the single biggest influence on a given index's makeup, higher prices naturally help drive performance. As a factor of time, you own increasingly high-priced stocks in increasingly greater proportion to the underlying index. The flip side is your exposure to the cheapest stocks dwindles as a factor of time. And this makes sense because?

When the music stops, which it always does, the exits are rushed and performance is dragged down not just by declines in stock prices but more so the wall of humanity that just doesn't fit through the door. Investors pile in together, in perfect harmony, and eventually pile out together, in a cacophonic craze.

Brave voices of dissent to the very idea of indexing are fewer and farther between these days. Thankfully, BNC National Bank's Chief Investment Officer Mark Peiler is one of them. "Given today's valuations, the math of returns tells me that index investors will likely experience another "lost decade" of low, zero, or negative returns from broad market index investments," Peiler ventures. "If you look at 10-year returns from 1966, 2000, and 2007 (nine years) returns are low to nonexistent."

Of course, Peiler refers to years that sported valuations in the same nosebleed section as today's. To correct for the perils of flying blind, he deploys four filters. Starting with the Russell 3000 index, Peiler nixes companies with inadequate liquidity, insufficient return on invested capital, overly levered balance sheets, and pricey valuations.

By the time this exhaustive exercise is complete, Peiler has whittled the pack down to 40 stocks that are worthy. Yes, 40. His novel theory to avoiding the pitfalls of what he calls the "Artificial Bull Market": the majority of ROIC should come to equity investors. Hear, hear!

A simpler approach involves a twist on indexing achieved simply by negating the price element from the equation by weighting a company by its price-to-cash-flow, perhaps. This tack has come to be known as Smart Beta.

Jim Bianco, President of Bianco Research LLC, is sublime in his succinctness of the logic of the approach: "As long as you get off price, you've won half the game."

But wait! There's more! Actively managed bond funds have shrunk by $16 billion thus far this year while passive bond funds have soaked up $41 billion. While index investing has not been around in bondland as long as it has in stocks, bond indexing holds even greater appeal for investors, which is worrying.

Why the angst? It would seem most bond funds are also price weighted. That means that in the wacky world in which we live, especially as it pertains to the relative 'safety' of global government bond funds, an investor is exposed first to the United States, next to Japan and third, but not to be back-seated, Italy. These countries happen to boast the world's top three sovereign bond markets on Planet Earth, in that order.

The weighting of a hypothetical bond index fund could therefore be anchored by a risk-free asset riddled with risk, a country that's vowed to keep its benchmark yield at zero for the next decade and one of the most fiscally reckless borrowers known to God and man. Feel better?

On a more fundamental level, it's so much more than fundamentals that are being sacrificed. Capitalism itself is at risk given the huge proportion of Corporate America that's owned by index funds.

The Economist recently quantified the scope of indexing's reach citing research out of the University of Amsterdam which tracks the holdings of the "Big Three" asset managers, Black Rock, Vanguard and State Street: "Treated as a single entity, they would now be the largest shareholder in just over 40 percent of listed American firms, which, adjusting for market capitalization, account for nearly 80 percent of the market."

"Capitalism is about rewarding good ideas and punishing bad ones," said Bianco. "If we're reducing investment allocations to a binary decision-making process, capital will by definition be less efficiently allocated. Where would this leave startup financing?"

Good question, Jim. Consider the energy patch if you're struggling to come up with a good example of what happens when this binary decision making process is allowed to operate unfettered. Way back when oil prices tanked, nearly everyone was predicting production would quickly follow suit. But something happened on the way to cause and effect coming to pass.

You see, energy issuers made up 18 percent of the high yield index. When struggling oil and gas producers were cut off by their no-longer-friendly neighborhood commercial banker, they turned to their investment bankers who directed them to the bond market, which obligingly kept the spigot open. Index funds, it would seem, needed the supply of fresh bond sales to satisfy investors' demands in the form of runaway inflows. The funds did not discriminate and malinvestment flowed freely to the oil patch.

As for the immediate future of index investing, look for the trend to continue until that ultimate something upsets the apple cart, as in investors' confidence in the Fed is finally shaken, not simply stirred. In the meantime, all but the most nimble and forward-looking active managers will keep dropping like flies, care of one critical difference between now and 1999.

Back then, 90 percent of managers were also failing to perform as well as their given index. Investors, however, were nonplussed because everything was up big, including their 'underperforming' active managers. Flash forward to the 12 months through June. That same 90 percent of active managers are underperforming, but stocks are up by only five percent. In far too many cases today, underperforming equates to outright losses.

The irony (there's always an irony) is active managers tend to outperform their benchmarks when markets turn south. Thankfully central bankers have outlawed bear markets. At least that's the premise on which investors are acting as they blindly place their full faith in passive investing.

See how they run!See how they run!Did you ever see such a thing in your life,As We Blind Mice?